This quarter marked my re-entry into the market, apart from one small position I've had for over 5 years. The positions were entered during the quarter, and thus each is a relatively short-term position of less than a month. The following is a summary of performance:
Positives (> 2% growth in quarter)
SOLR - $8.37, +3.76% change from purchase, 4.3% of portfolio
PALL - $56.38, +6.85%, 4.8%
JEF - $22.69, +7.78% change during Q, 2.8% (LT position)
Neutral (> neg 2%, < 2%)
HUN - $11.56, -0.43% change from purchase, 3.9% of portfolio
DBA - $27.48, -0.39%, 9.3%
Cash - 60.7% of portfolio
Negatives (< neg 2%)
TBT - $31.25, -5.66% change from purchase, 13.3% of portfolio
VXX - $17.29, -4.03%, 3.7%
Q3 Change in Portfolio Balance, net expenses - Negative 31 bps.
Potential Trades
The one position I am looking to change is VXX, which I expect to exit during a period of volatility in the next month. Otherwise I expect to be 90+% invested by year-end.
Macro Outlook
As worries about a double dip fade into the background, I believe investors appetite for risk may increase during the fourth quarter. The Federal Reserve likely lets the large growth in money supply continue to slosh around the world economies, encouraging inflation and bubbles in asset prices. Should equity markets begin to rally on the Fed's inflationary efforts, investors may increasingly shift funds away from bonds. The 13% position in TBT is designed to take full advantage of this anticipated swing. TBT has worked against me so far, but I remain confident it will ultimately prove profitable.
As rising inflation allays deflationary fears and creates the feeling of improving economies, I expect commodities and companies deep in the supply chain to rise first. The positions in PALL, SOLR, and HUN are designed to take advantage of this anticipated trend. Weaved into these positions are also high exposures to U.S. exporters and an effort to gain exposure to anticipated high growth industries, such as solar energy. A weakening dollar and health in developing economies are expected to aid exporters. I expect to put in additional equity positions on an opportunistic basis designed to take advantage of these trends.
Playing on rising inflation and improving developing economies is the DBA position, which should also diversify the portfolio somewhat into commodities not related to technology and industry. The VXX position is designed to take advantage of any near-term volatility in equity markets. I expect to be out of this position in a couple weeks, either because it worked or didn't.
Quick Company Outlooks
SOLR - FY11 (Mar) EPS guidance of $0.90-$1.00, FY12 EPS estimate of $0.89. FY12 appears quite conservative given SOLR's largest customer recently received new financing arrangements to make capital purchases. A P/E of 9x FY12 would appear to expect a slowdown in earnings, so any EPS increases should enjoy multiple expansion.
HUN - C10 EPS estimate of $0.45, C11 EPS estimate of $0.88. Analysts expect a robust bounce next year in earnings, although growth is skewed somewhat by a large special charge in 1Q10. A return to a more normal demand environment likely returns the EPS to well above $1. Estimates may prove aggressive in 2011 but with a 3+% dividend yield there should be support for stock. If estimates prove fair, stock should perform quite well with multiple expansion.
Thursday, September 30, 2010
Playing China
Put in an order to buy a ~10% position in Matthews China Fund (Ticker: MCHFX).
Positives:
(1) Portfolio managers share a similar outlook as I do.
(2) Prefer a basket of investment approach in China to diversify risk and to have a "hand on the tiller" in the form of active investments to help position investments into stronger segments of China's economy.
(3) Fund should benefit from any loosening of the exchange rate between dollars and yuan.
Negatives:
(1) Political and currency risks as the U.S. Congress considers trade sanctions against the China. Any cheap voter pandering by U.S. politicians could result in retaliation by China.
(2) Market risk as China's equity markets are volatile.
(3) Relatively high expense fee of 1.21%
Positives:
(1) Portfolio managers share a similar outlook as I do.
(2) Prefer a basket of investment approach in China to diversify risk and to have a "hand on the tiller" in the form of active investments to help position investments into stronger segments of China's economy.
(3) Fund should benefit from any loosening of the exchange rate between dollars and yuan.
Negatives:
(1) Political and currency risks as the U.S. Congress considers trade sanctions against the China. Any cheap voter pandering by U.S. politicians could result in retaliation by China.
(2) Market risk as China's equity markets are volatile.
(3) Relatively high expense fee of 1.21%
Wednesday, September 29, 2010
Waiting for the World to Change
I have established a 4% position in the Barclays Bank PLC IPath S&P 500 VIX (Ticker VXX), a truly horrible ETF. I believe there are some fundamental problem with this ETF of which investors should be wary, including value decay.
The VXX position is short-term (< 1 month) as I wait to see if the markets will pull in due to European debt concerns, or changing trade policies with Asia. I am also pondering earnings season and its impact on the markets, which I'm leaning towards bullish given relatively low valuations.
I continue to maintain my thesis that the stock market is ready for a bullish inflation-driven run in the next 1-3 months. I also maintain that fundamentals will remain mixed, at best, for the foreseeable future.
The VXX position is short-term (< 1 month) as I wait to see if the markets will pull in due to European debt concerns, or changing trade policies with Asia. I am also pondering earnings season and its impact on the markets, which I'm leaning towards bullish given relatively low valuations.
I continue to maintain my thesis that the stock market is ready for a bullish inflation-driven run in the next 1-3 months. I also maintain that fundamentals will remain mixed, at best, for the foreseeable future.
Tuesday, September 28, 2010
GT Solar International (Ticker: SOLR)
I established a 4% position in GT Solar International, ticker SOLR, at $8.06
SOLR designs and sells capital equipment and related services used in both the polysilicon production and ingot production segments of the PV manufacturing process.
Positives:
(1) Positioned as supplier to accelerating solar industry. Equipment supplier to manufacturers of solar cells and panels, an industry expected to grow at an annual rate of well in excess of 20% over the next few years. Through the Crystal Systems acquisition GT Solar is also a provider in the LED market, expected to grow at an annual rate in excess of 20% over the next few years.
(2) Largest customer, LDK Solar (Ticker LDK) yesterday announced a major financing arrangement for $8.9 billion to enable it to expand its capacity. This financing should translate into future orders for GT Solar, which may come sooner rather than later if LDK has been waiting for financing before placing orders.
(3) Hitting positive screening points. Raised F11 revenue and EPS guidance in August to $700-775 million and $0.90 and $1.00 with a book-to-bill of 2.6x. P/E of 9x on the consensus F11 EPS estimate of $0.92, with F12 appearing conservative at $0.89 offering opportunities for estimate increases. High Return on Investment of over 50% during the past year. No debt and healthy cash balance of $276 million, driven primarily by health free cash flow. Exporter of durable goods that should benefit from a weakening dollar. Company should be able to pass along cost increases of raw materials. Potential acquisition target if industry consolidates vertically.
Negatives:
(1) Spotty operating history with large sporadic orders for equipment that can cause revenue and earnings misses.
(2) Potentially hurt by trade war between the U.S. and China.
(3) Competitive marketplace with national interests potentially skewing orders.
(3) Large Private Equity shareholder likely provides selling pressure in future, although the company just completed a follow-on offering as a liquidity event for investors.
Monday, September 27, 2010
Huntsman Corp. (Ticker: HUN)
Today I established 4% position in Huntsman Corp, ticker HUN, at $11.60.
Positives include:
(1) Ability to pass along raw material cost increases to customers in the form of price increases. Based on my macro outlook of accelerating price inflation over the next few quarters I expect revenue growth to accelerate from both rising prices and increasing demand.
(2) Latin America and Asia represent about one-third of revenue and are the fastest growing regions. With idle capacity in many of its product lines, there should be ample room to meet rising demand. Additionally, the company should benefit from weakening of the US dollar as foreign sales are converted to dollars for reporting purposes.
(3) Valuation is attractive with a 3.5% dividend yield and a 13x P/E on the consensus 2011 EPS estimate of $0.88. Six analysts cover the stock with five at a Hold rating, offering dry powder for upgrades.
As time allows I will continue to work on this idea, fleshing out the investment thesis and investment risks.
Positives include:
(1) Ability to pass along raw material cost increases to customers in the form of price increases. Based on my macro outlook of accelerating price inflation over the next few quarters I expect revenue growth to accelerate from both rising prices and increasing demand.
(2) Latin America and Asia represent about one-third of revenue and are the fastest growing regions. With idle capacity in many of its product lines, there should be ample room to meet rising demand. Additionally, the company should benefit from weakening of the US dollar as foreign sales are converted to dollars for reporting purposes.
(3) Valuation is attractive with a 3.5% dividend yield and a 13x P/E on the consensus 2011 EPS estimate of $0.88. Six analysts cover the stock with five at a Hold rating, offering dry powder for upgrades.
As time allows I will continue to work on this idea, fleshing out the investment thesis and investment risks.
Thursday, September 23, 2010
Sagflation Likely Challenges All
Initial unemployment claims increased 12,000 to 465,000 last week, above expectations of 450,000. Existing home sales in August increased over 7%. The Index of Leading Indicators increased 0.3% in August, above the estimate of 0.1% and improving from 0.1% in July. Industries benefiting from low borrowing costs, like the auto sector, seem to be improving while industries hurt by low interest rates, like some financial sectors, I fear are struggling or taking on excessive risk to meet sales targets.
As I argued in my "sagflation" post on August 27, the U.S. economy may be entering a period of higher price volatility coupled with slower economic growth. On the positive side, I believe the flexibility of the U.S. economy to restructure and rationalize capital is quickening the pace of healthy long-term economic changes. However, I would argue that this is still a multi-year trend due to the amount of excess capital mis-invested over the past few decades. Exasperating the economic weakness is an outlook of increased regulatory activity and austerity, a product of the high debt levels today, promised benefits levels, and high deficits projected near-term.
Not surprising then that the Federal Reserve continues to threaten more monetization measures as it throws trillions of dollars into the market to stimulate economic growth. For this reason I believe after 1-3 months of muddled signals the first swing in prices is likely upward, in the form of unexpected inflation acceleration. How this acceleration is perceived in the market will be interesting. At first it may appear as though the economy is improving, boosting equity prices and relaxing the Fed's aggressive actions. Despite these apparent improvements, businesses likely continue to feel pressure from weak competitors remaining in the marketplace due to lower capital costs and from rising costs associated with higher commodity costs. Thus hiring may remain weak, unemployment high, certain industries ballooning, M&A active, all while the real economy struggles.
A key question is how much inflation how quickly? If the Fed dances through this minefield without blowing us up, then maybe inflation of 3-4% before settling back. If China's policies exasperate the pent-up inflation potential in the system and the Fed remains aggressive, then inflation could spike higher. It is a spike that I most fear because of its impact on treasuries, the dollar, business uncertainty, and the Fed's future actions.
I remain cautious on U.S. equities in the near-term but would like to establish positions on an opportunistic basis. Pricing power is a key characteristic of any attractive companies, in my view, both to pass-on inflationary costs and as an indicator of a favorable competitive landscape. Again, I also remain focused on companies with higher foreign non-dollar exposure. As a retail investor I likely have to play a few international ETFs and mutual funds in order to gain exposure on a cost effective basis.
As I argued in my "sagflation" post on August 27, the U.S. economy may be entering a period of higher price volatility coupled with slower economic growth. On the positive side, I believe the flexibility of the U.S. economy to restructure and rationalize capital is quickening the pace of healthy long-term economic changes. However, I would argue that this is still a multi-year trend due to the amount of excess capital mis-invested over the past few decades. Exasperating the economic weakness is an outlook of increased regulatory activity and austerity, a product of the high debt levels today, promised benefits levels, and high deficits projected near-term.
Not surprising then that the Federal Reserve continues to threaten more monetization measures as it throws trillions of dollars into the market to stimulate economic growth. For this reason I believe after 1-3 months of muddled signals the first swing in prices is likely upward, in the form of unexpected inflation acceleration. How this acceleration is perceived in the market will be interesting. At first it may appear as though the economy is improving, boosting equity prices and relaxing the Fed's aggressive actions. Despite these apparent improvements, businesses likely continue to feel pressure from weak competitors remaining in the marketplace due to lower capital costs and from rising costs associated with higher commodity costs. Thus hiring may remain weak, unemployment high, certain industries ballooning, M&A active, all while the real economy struggles.
A key question is how much inflation how quickly? If the Fed dances through this minefield without blowing us up, then maybe inflation of 3-4% before settling back. If China's policies exasperate the pent-up inflation potential in the system and the Fed remains aggressive, then inflation could spike higher. It is a spike that I most fear because of its impact on treasuries, the dollar, business uncertainty, and the Fed's future actions.
I remain cautious on U.S. equities in the near-term but would like to establish positions on an opportunistic basis. Pricing power is a key characteristic of any attractive companies, in my view, both to pass-on inflationary costs and as an indicator of a favorable competitive landscape. Again, I also remain focused on companies with higher foreign non-dollar exposure. As a retail investor I likely have to play a few international ETFs and mutual funds in order to gain exposure on a cost effective basis.
Tuesday, September 21, 2010
Positions Entered
Following up on the last post, I have established the following positions:
DBA - ~10% @ $27.58
PALL - ~5% @ $52.72
TBT - ~15% @ $33.12
Each of these positions are a bet on inflation and weakness in the U.S. dollar. I understand taking these positions is relatively risky prior to the Federal Reserve meeting today however, I believe the risk/ reward is in favor of a bearish view on Treasury prices since it would take around $2 trillion of security purchases to push yields on 10-year notes by 1%. Even if the Fed does announce a major asset purchase program this week, I believe it will only fuel faster inflation growth in the next 1-6 months. So I'm prepared to take a short-term risk for what I perceive will pay-off by the end of the year.
The PALL and DBA positions are an effort to cover inflationary pressure, in general, growing demand for food in developing China and India, and a potential perceived improvement in the U.S. economy (and an aggressive purchase of materials by tech companies fearful of being behind the curve) associated with inflation acceleration.
Powershares DB Agricultural Fund (Ticker: DBA): "The investment seeks to track the price and yield performance, before fees and expenses, of the Deutsche Bank Liquid Commodity Index - Optimum Yield Agriculture Excess Return. The index is a rules-based index composed of futures contracts on some of the most liquid and widely traded agricultural commodities – corn, wheat, soy beans and sugar. The index is intended to reflect the performance of the agricultural sector."
ETFS Physical Palladium Shares (Ticker: PALL): "The investment seeks to reflect the performance of the price of physical palladium, less the expenses of the Trust’s operations. The fund is designed for investors who want a cost-effective and convenient way to invest in palladium with minimal credit risk. Advantages of investing in the Shares include: Ease and Flexibility of Investment, Expenses, Minimal Credit Risk."
Proshares Ultrashort 20+ Year Treasury (Ticker: TBT): "The investment seeks daily investment results, before fees and expenses and interest income earned on cash and financial instruments, that correspond to twice (200%) the inverse (opposite) of the daily performance of the Barclays Capital 20+ Year U.S. Treasury Bond index. The fund invests in derivatives that advisors believes should have similar daily return characteristics as twice (200%) the inverse of the daily performance of the Index. It invests typically the rest of the assets in money market instruments. The fund is non-diversified.
DBA - ~10% @ $27.58
PALL - ~5% @ $52.72
TBT - ~15% @ $33.12
Each of these positions are a bet on inflation and weakness in the U.S. dollar. I understand taking these positions is relatively risky prior to the Federal Reserve meeting today however, I believe the risk/ reward is in favor of a bearish view on Treasury prices since it would take around $2 trillion of security purchases to push yields on 10-year notes by 1%. Even if the Fed does announce a major asset purchase program this week, I believe it will only fuel faster inflation growth in the next 1-6 months. So I'm prepared to take a short-term risk for what I perceive will pay-off by the end of the year.
The PALL and DBA positions are an effort to cover inflationary pressure, in general, growing demand for food in developing China and India, and a potential perceived improvement in the U.S. economy (and an aggressive purchase of materials by tech companies fearful of being behind the curve) associated with inflation acceleration.
Powershares DB Agricultural Fund (Ticker: DBA): "The investment seeks to track the price and yield performance, before fees and expenses, of the Deutsche Bank Liquid Commodity Index - Optimum Yield Agriculture Excess Return. The index is a rules-based index composed of futures contracts on some of the most liquid and widely traded agricultural commodities – corn, wheat, soy beans and sugar. The index is intended to reflect the performance of the agricultural sector."
ETFS Physical Palladium Shares (Ticker: PALL): "The investment seeks to reflect the performance of the price of physical palladium, less the expenses of the Trust’s operations. The fund is designed for investors who want a cost-effective and convenient way to invest in palladium with minimal credit risk. Advantages of investing in the Shares include: Ease and Flexibility of Investment, Expenses, Minimal Credit Risk."
Proshares Ultrashort 20+ Year Treasury (Ticker: TBT): "The investment seeks daily investment results, before fees and expenses and interest income earned on cash and financial instruments, that correspond to twice (200%) the inverse (opposite) of the daily performance of the Barclays Capital 20+ Year U.S. Treasury Bond index. The fund invests in derivatives that advisors believes should have similar daily return characteristics as twice (200%) the inverse of the daily performance of the Index. It invests typically the rest of the assets in money market instruments. The fund is non-diversified.
Saturday, September 18, 2010
The Next Bubble to Unwind
This week The Wall Street Journal's Opinion section had an interesting article outlining the unsustainable Chinese monetary policy that is impacting world markets. In the article, the Journal outlines the monetary policy of "sterilization," a specific combination of monetary and exchange policy in which the government attempts to peg its currency while maintaining price stability. Since economic theory argues the difficulty of perpetually maintaining both price stability and a fixed exchange rate, a trade surplus persists and grows with productivity gains and pressure builds within the monetary system.
The market mechanisms work basically as the following: To keep the yuan pegged to the dollar the Chinese government has been selling yuan to buy dollars. As of the end of June China had foreign reserves of $2.5 trillion, up 15% annually. In order to offset the upward pressure on Chinese prices as a result of selling yuan, the government has been selling securities and increasing the reserve requirements of banks. A recent article highlighted that the Chinese may increase the reserve requirement to 15% in 2012 from 11.5% currently, which is more aggressive than even the levels outlined in Basel III for world banks. This in essence requires the banks to hold a larger percentage of their deposits in liquid cash, reducing the amount of loans the bank can offer and offsetting the growth the money supply by reducing the money multiplier.
Despite these restrictive monetary policies the Chinese inflation rate increased to 3.5% in August, above the stated long-term goal of 3%. To offset the rising inflationary pressure there have been some opinions that the Chinese central bank may increase its one-year yuan lending rate at 5.31% and one-year yuan deposit rate at 2.25%. Raising the interest rate should apply greater pressure to the brakes of the economy. Between the rising reserve requirement, selling of securities, and potentially increasing central bank one-year rates; it would appear the Chinese government is pushing hard on the brakes. The problem is that the pegged exchange rate is acting like accelerator, which is increasing inflationary pressure as productivity and the economy grows. Thus the Chinese government is effectively driving with both feet. The policy also encourages over-investment in export industries, driving mini-bubbles within China's economy to the determinant of longer-term profits and domestic consumption.
The actions by the Chinese have exasperated the situation in the U.S. by driving down interest rates and encouraging consumption of Chinese goods due to their relative price advantage. It has also, I would argue, applied deflationary pressure in the U.S. since demand for dollars (purchased by the Chinese) has outpaced the 6% CAGR over the past 13 years in supply. The Chinese demand for dollars combined with the raised reserve requirements for U.S. banks, stricter U.S. bank regulations, and economic slowdown has created the environment in which the Federal Reserve could shower trillions of dollars into the market without creating inflation, for now.
Upcoming catalysts to change an unsustainable situation, or bubble, are appearing on the horizon. In the previously mentioned opinion article, The Wall Street Journal highlights that Chinese reform to boost domestic income is increasingly discussed by top officials. This reform likely involves some combination of increased worker benefits, monetary policy and exchange policy. The U.S. Congress is considering acting to punish China for the perceived currency manipulations, which depending on how carefully legislation is written and administered could nudge China to move faster or lead to a trade war hurtful to both sides.
So does the bubble go out with a bang? Or, a fizzle? A lot depends on how coordinated the U.S. and China act on these issues. If Congress tries to win cheap political points with voters by casting China as the villain and decides to punish the country too harshly, it could get ugly. If monetary policies on both sides are not careful, releasing the pent-up pressure could produce a surprising spike in U.S. inflation and recession in China. The one trend I do foresee is rising interest rates within the U.S., either as a sudden pop or a long 10-30 year cycle. Just as China's currency policy possibly provided deflationary pressure during a pegged time period, a loosening of the fixed exchange rate likely causes inflationary pressure as the demand for dollars moderates. This moderation coupled with the Fed's aggressive monetary policies potentially creates an inflationary period, increasing interest rates and therefore lowering treasury prices.
How to play it?
I will establish a relatively large position (5-15%) in an inverse leveraged Treasury ETF. I have been debating with myself as to whether to wait until October and a potential stock market drop, coupled with strengthening treasury prices, or to not get too cute and do it now. Given I think the position should pay-off in the next year, and likely continue to work for 5+ years, I'm inclined to establish the position and deal with any short-term rises in treasury prices associated with recovery concerns.
Other potential positions include net long yuan versus dollar, industries catering to domestic China, short-term (<1 year) long positions in exporters to Asia, and long positions in agriculture and other commodities imported by China.
The market mechanisms work basically as the following: To keep the yuan pegged to the dollar the Chinese government has been selling yuan to buy dollars. As of the end of June China had foreign reserves of $2.5 trillion, up 15% annually. In order to offset the upward pressure on Chinese prices as a result of selling yuan, the government has been selling securities and increasing the reserve requirements of banks. A recent article highlighted that the Chinese may increase the reserve requirement to 15% in 2012 from 11.5% currently, which is more aggressive than even the levels outlined in Basel III for world banks. This in essence requires the banks to hold a larger percentage of their deposits in liquid cash, reducing the amount of loans the bank can offer and offsetting the growth the money supply by reducing the money multiplier.
Despite these restrictive monetary policies the Chinese inflation rate increased to 3.5% in August, above the stated long-term goal of 3%. To offset the rising inflationary pressure there have been some opinions that the Chinese central bank may increase its one-year yuan lending rate at 5.31% and one-year yuan deposit rate at 2.25%. Raising the interest rate should apply greater pressure to the brakes of the economy. Between the rising reserve requirement, selling of securities, and potentially increasing central bank one-year rates; it would appear the Chinese government is pushing hard on the brakes. The problem is that the pegged exchange rate is acting like accelerator, which is increasing inflationary pressure as productivity and the economy grows. Thus the Chinese government is effectively driving with both feet. The policy also encourages over-investment in export industries, driving mini-bubbles within China's economy to the determinant of longer-term profits and domestic consumption.
The actions by the Chinese have exasperated the situation in the U.S. by driving down interest rates and encouraging consumption of Chinese goods due to their relative price advantage. It has also, I would argue, applied deflationary pressure in the U.S. since demand for dollars (purchased by the Chinese) has outpaced the 6% CAGR over the past 13 years in supply. The Chinese demand for dollars combined with the raised reserve requirements for U.S. banks, stricter U.S. bank regulations, and economic slowdown has created the environment in which the Federal Reserve could shower trillions of dollars into the market without creating inflation, for now.
Upcoming catalysts to change an unsustainable situation, or bubble, are appearing on the horizon. In the previously mentioned opinion article, The Wall Street Journal highlights that Chinese reform to boost domestic income is increasingly discussed by top officials. This reform likely involves some combination of increased worker benefits, monetary policy and exchange policy. The U.S. Congress is considering acting to punish China for the perceived currency manipulations, which depending on how carefully legislation is written and administered could nudge China to move faster or lead to a trade war hurtful to both sides.
So does the bubble go out with a bang? Or, a fizzle? A lot depends on how coordinated the U.S. and China act on these issues. If Congress tries to win cheap political points with voters by casting China as the villain and decides to punish the country too harshly, it could get ugly. If monetary policies on both sides are not careful, releasing the pent-up pressure could produce a surprising spike in U.S. inflation and recession in China. The one trend I do foresee is rising interest rates within the U.S., either as a sudden pop or a long 10-30 year cycle. Just as China's currency policy possibly provided deflationary pressure during a pegged time period, a loosening of the fixed exchange rate likely causes inflationary pressure as the demand for dollars moderates. This moderation coupled with the Fed's aggressive monetary policies potentially creates an inflationary period, increasing interest rates and therefore lowering treasury prices.
How to play it?
I will establish a relatively large position (5-15%) in an inverse leveraged Treasury ETF. I have been debating with myself as to whether to wait until October and a potential stock market drop, coupled with strengthening treasury prices, or to not get too cute and do it now. Given I think the position should pay-off in the next year, and likely continue to work for 5+ years, I'm inclined to establish the position and deal with any short-term rises in treasury prices associated with recovery concerns.
Other potential positions include net long yuan versus dollar, industries catering to domestic China, short-term (<1 year) long positions in exporters to Asia, and long positions in agriculture and other commodities imported by China.
Tuesday, September 14, 2010
Kernal of an Investment Strategy
Two broad themes I expect to guide my investment decisions for the next decade:
(1) On-going maturation of economies in Latin America and Asia. Increasing GDP per capita in these regions should drive increasing demand for basics (food and clothing), enabling investments (such as improved communication), and luxury items.
Based on this outlook, I plan a more passive investment approach focused on a basket of country-focused ETFs. Improving economies and strengthening emerging currencies are broad trends I expect to play. As far as allocation, I expect my portfolio to maintain around 50% exposure to this trend.
(2) Price Volatility in U.S. and Europe. Bubbles formed and popped as the allocation of capital is swirled by activist monetary policy, exasperated by the three-D's - Debt, Deficits and Defaults. Regulation and austerity are likely dominant themes with more focus by business on improving returns than growing its capital base.
The second trend suggests skill as a stock picker will be at a premium. It also suggests a business community more uncertain about making investments, in general, resulting in minimal growth over 5-10 years. At a micro level, managers will need to remain nimble, adjusting prices to offset cost fluctuations and demand trends. We may collectively go through greater booms and deeper bottoms. This will put a premium on manager quality. I will look for unusual market dynamics that may lead to bubbles, management quality, and healthy secular trends driving specific companies.
(1) On-going maturation of economies in Latin America and Asia. Increasing GDP per capita in these regions should drive increasing demand for basics (food and clothing), enabling investments (such as improved communication), and luxury items.
Based on this outlook, I plan a more passive investment approach focused on a basket of country-focused ETFs. Improving economies and strengthening emerging currencies are broad trends I expect to play. As far as allocation, I expect my portfolio to maintain around 50% exposure to this trend.
(2) Price Volatility in U.S. and Europe. Bubbles formed and popped as the allocation of capital is swirled by activist monetary policy, exasperated by the three-D's - Debt, Deficits and Defaults. Regulation and austerity are likely dominant themes with more focus by business on improving returns than growing its capital base.
The second trend suggests skill as a stock picker will be at a premium. It also suggests a business community more uncertain about making investments, in general, resulting in minimal growth over 5-10 years. At a micro level, managers will need to remain nimble, adjusting prices to offset cost fluctuations and demand trends. We may collectively go through greater booms and deeper bottoms. This will put a premium on manager quality. I will look for unusual market dynamics that may lead to bubbles, management quality, and healthy secular trends driving specific companies.
Wednesday, September 1, 2010
Sagflation - Deflation Pressure Starts Abating in 2011
Investment Summary
Two deflationary trends likely reverse over the next year, in my view. These reversals, coupled with the Fed increasingly more aggressive actions, likely result in accelerating inflation after a short period of deflation, in my view. While prices are potentially whipsawed, Real GDP likely continues to slow for 3+ months due to uncertain business costs and demand for products and services. Should the government allow the economy to re-allocate capital efficiently, the good news is the U.S. sets up for healthy growth within specific segments in the long-term, in my view.
Exporters, South American and Canadian raw material providers, and Asian consumer companies are all high on my radar for positive long-term trends. Bearish positions on Treasuries and bets on volatility are potential short-term positions in September and October as I prepare to wade back in.
Deflation Deconstructed
Deflation is caused by three basic market dynamics, which are money supply growth exceeding demand, improved productivity, and recessions. In my view, all three dynamics have had a role in creating the current environment of deflationary fears. The first two of these dynamics are reversing, in my view, with the ultimate impact on real economic growth likely complex. This resulting complexity offers properly positioned active investors exceptional returns, while passive index-focused investors are potentially loss leaders.
The most basic cause for deflation is the growth of money supply exceeds the growth in population. The tricky part in this equation is how to measure the population. It is more than simply the U.S. population since many foreigners (defined as people, companies and countries outside the U.S.) hold U.S. dollars. When China buys U.S. Treasuries it does so with U.S. dollars, thereby increasing the demand the U.S. dollars. It is no secret that the the U.S. has sold a lot of debt over the past couple decades, of which a large portion is owned by foreigners. So long as foreigners continue to buy our expanding debt, demand for the U.S. dollar remains healthy and the supply of our currency must grow faster than our GDP. This explains why the money supply of U.S. dollars has increased at a compounded annual growth rate (CAGR) of over 6% for 13+ years, despite economic growth below this level. While a healthy growth rate for money, deflationary pressure could be from the U.S. government not increasing the supply of dollars fast enough to satiate the growing demand for dollars around the world.
The second cause of deflation is structural, resulting from improved productivity. During the last quarter of the 19th century the U.S. experienced deflation possibly aided by technology improvements like the railroad and telegraph. Assuming a competitive market, companies that improve their productivity pass along some of their cost savings to customers in the form of lower costs. It is highly plausible that the technology advancements over the past 30+ years has increased productivity and therefore enabled businesses to pass along these cost savings to their customers. I believe this scenario is even more likely given the Fed's actions of lowering interest rates and therefore allowing less healthy companies to remain in business, therby apply pricing pressures in the economy.
The third cause of deflation is a general decline in economic activity during a recession or depression. This type of deflation can become a virtuous cycle due to deflation creating disincentives to invest money and consume products and services. During periods when this is the cause of deflation the government may need to stimulate demand through fiscal policies and directly increase the money supply, called quantitative easing, through more extraordinary action like asset purchases.
The first two deflationary trends may be reversing, in my view.
Fundamental demand for U.S. dollars may be starting to slow due to more viable alternative currencies, active policies by foreign companies, and general concern about the relative economic strength of the U.S. economy. China recently began selling a small portion of its holdings in U.S. Treasuries, likely reducing their holdings of U.S. dollars in the process. Furthermore, China announced last week that it is allowing foreign entities to invest their yuan holdings in China's sovereign debt to supplement their decision last year to allow all imports and exports to be settled in yuan, in lieu of dollars. Incremental demand for dollars declines from both of these actions by China. While these actions are relatively small compared to the overall level of dollars outstanding, if these actions accelerate the longer-term trend is worrying. While impossible to quantify, there are also some signs that the market for illegal products and services is adopting the euro at the expense of the dollar, which has traditionally been the currency of choice. The number of euro notes in existence has grown at an annual rate of 32% since 2002, with 500 euro notes accounting for 35% of the value in circulation. If nothing else, it appears as though fewer U.S. dollars are demanded in the world.
In the August 27 post I laid out the string of finite stimuli that have driven above sustainable growth in the U.S. for the past 30 years. One of the main drivers was improving productivity from increasingly connected and increasingly more powerful computers, as well as outsourcing manufacturing and services to lower cost geographic regions like China and India. Cloud computing likely provides further productivity improvements for companies, but we are past the bulge of productivity gains, in my view. I believe efficiency continues to improve, just not at the pace it was for the past 20 years. Therefore, I believe the deflationary pressures from productivity gains likely lessens going forward.
So do the first two trends, coupled with an inefficient base of invested capital as discussed in earlier posts, lead us to a recession, hyper-inflation, a combination, or something else (D-word)? Let's start with the assumptions that the economy continues to weaken in 2010 and the Fed likely throws everything it has to stave off deflation. This may mean a negative Fed funds rate, aggressive language, increasing asset purchases, and loosening restrictions on banks. Simply put, these two assumptions imply that supply of money grows faster than the demand for money. While this situation may last for a relatively short 2-6 months, the combination of weakening GDP and aggressive government actions likely weakens equity markets. Bond yields likely fall and the U.S. dollar may actually strengthen as investors seek its perceived safety. The excess money likely distributes unevenly in the economy, possibly inflating segment bubbles.
How does this play out longer-term? The good news is that the U.S. has efficient markets to handle the swings in currency, debt and equity markets; thereby re-allocating capital to the best purposes and hopefully avoiding a decade-plus re-calibration. The recent increase in M&A activity and the 100+ bank failures in 2010 are two indicators of markets already re-allocating capital. Should the U.S. dollar weaken we would likely see businesses invest domestically as foreign costs increase, like Whirlpool's recent decision. These efficient mechanisms for re-allocating capital helps quicken economic improvements. The bad news is that the U.S. has efficient markets that likely swing wildly until a new equilibrium is found. Segment bubbles may be formed and popped, possibly with long-term negative effects. It could be painful for investors, workers, and companies who will need to adjust quickly and likely build up new skills. The wild card is government action that may prolong the issues or even deepen the crisis.
Two deflationary trends likely reverse over the next year, in my view. These reversals, coupled with the Fed increasingly more aggressive actions, likely result in accelerating inflation after a short period of deflation, in my view. While prices are potentially whipsawed, Real GDP likely continues to slow for 3+ months due to uncertain business costs and demand for products and services. Should the government allow the economy to re-allocate capital efficiently, the good news is the U.S. sets up for healthy growth within specific segments in the long-term, in my view.
Exporters, South American and Canadian raw material providers, and Asian consumer companies are all high on my radar for positive long-term trends. Bearish positions on Treasuries and bets on volatility are potential short-term positions in September and October as I prepare to wade back in.
Deflation Deconstructed
Deflation is caused by three basic market dynamics, which are money supply growth exceeding demand, improved productivity, and recessions. In my view, all three dynamics have had a role in creating the current environment of deflationary fears. The first two of these dynamics are reversing, in my view, with the ultimate impact on real economic growth likely complex. This resulting complexity offers properly positioned active investors exceptional returns, while passive index-focused investors are potentially loss leaders.
The most basic cause for deflation is the growth of money supply exceeds the growth in population. The tricky part in this equation is how to measure the population. It is more than simply the U.S. population since many foreigners (defined as people, companies and countries outside the U.S.) hold U.S. dollars. When China buys U.S. Treasuries it does so with U.S. dollars, thereby increasing the demand the U.S. dollars. It is no secret that the the U.S. has sold a lot of debt over the past couple decades, of which a large portion is owned by foreigners. So long as foreigners continue to buy our expanding debt, demand for the U.S. dollar remains healthy and the supply of our currency must grow faster than our GDP. This explains why the money supply of U.S. dollars has increased at a compounded annual growth rate (CAGR) of over 6% for 13+ years, despite economic growth below this level. While a healthy growth rate for money, deflationary pressure could be from the U.S. government not increasing the supply of dollars fast enough to satiate the growing demand for dollars around the world.
The second cause of deflation is structural, resulting from improved productivity. During the last quarter of the 19th century the U.S. experienced deflation possibly aided by technology improvements like the railroad and telegraph. Assuming a competitive market, companies that improve their productivity pass along some of their cost savings to customers in the form of lower costs. It is highly plausible that the technology advancements over the past 30+ years has increased productivity and therefore enabled businesses to pass along these cost savings to their customers. I believe this scenario is even more likely given the Fed's actions of lowering interest rates and therefore allowing less healthy companies to remain in business, therby apply pricing pressures in the economy.
The third cause of deflation is a general decline in economic activity during a recession or depression. This type of deflation can become a virtuous cycle due to deflation creating disincentives to invest money and consume products and services. During periods when this is the cause of deflation the government may need to stimulate demand through fiscal policies and directly increase the money supply, called quantitative easing, through more extraordinary action like asset purchases.
The first two deflationary trends may be reversing, in my view.
Fundamental demand for U.S. dollars may be starting to slow due to more viable alternative currencies, active policies by foreign companies, and general concern about the relative economic strength of the U.S. economy. China recently began selling a small portion of its holdings in U.S. Treasuries, likely reducing their holdings of U.S. dollars in the process. Furthermore, China announced last week that it is allowing foreign entities to invest their yuan holdings in China's sovereign debt to supplement their decision last year to allow all imports and exports to be settled in yuan, in lieu of dollars. Incremental demand for dollars declines from both of these actions by China. While these actions are relatively small compared to the overall level of dollars outstanding, if these actions accelerate the longer-term trend is worrying. While impossible to quantify, there are also some signs that the market for illegal products and services is adopting the euro at the expense of the dollar, which has traditionally been the currency of choice. The number of euro notes in existence has grown at an annual rate of 32% since 2002, with 500 euro notes accounting for 35% of the value in circulation. If nothing else, it appears as though fewer U.S. dollars are demanded in the world.
In the August 27 post I laid out the string of finite stimuli that have driven above sustainable growth in the U.S. for the past 30 years. One of the main drivers was improving productivity from increasingly connected and increasingly more powerful computers, as well as outsourcing manufacturing and services to lower cost geographic regions like China and India. Cloud computing likely provides further productivity improvements for companies, but we are past the bulge of productivity gains, in my view. I believe efficiency continues to improve, just not at the pace it was for the past 20 years. Therefore, I believe the deflationary pressures from productivity gains likely lessens going forward.
So do the first two trends, coupled with an inefficient base of invested capital as discussed in earlier posts, lead us to a recession, hyper-inflation, a combination, or something else (D-word)? Let's start with the assumptions that the economy continues to weaken in 2010 and the Fed likely throws everything it has to stave off deflation. This may mean a negative Fed funds rate, aggressive language, increasing asset purchases, and loosening restrictions on banks. Simply put, these two assumptions imply that supply of money grows faster than the demand for money. While this situation may last for a relatively short 2-6 months, the combination of weakening GDP and aggressive government actions likely weakens equity markets. Bond yields likely fall and the U.S. dollar may actually strengthen as investors seek its perceived safety. The excess money likely distributes unevenly in the economy, possibly inflating segment bubbles.
How does this play out longer-term? The good news is that the U.S. has efficient markets to handle the swings in currency, debt and equity markets; thereby re-allocating capital to the best purposes and hopefully avoiding a decade-plus re-calibration. The recent increase in M&A activity and the 100+ bank failures in 2010 are two indicators of markets already re-allocating capital. Should the U.S. dollar weaken we would likely see businesses invest domestically as foreign costs increase, like Whirlpool's recent decision. These efficient mechanisms for re-allocating capital helps quicken economic improvements. The bad news is that the U.S. has efficient markets that likely swing wildly until a new equilibrium is found. Segment bubbles may be formed and popped, possibly with long-term negative effects. It could be painful for investors, workers, and companies who will need to adjust quickly and likely build up new skills. The wild card is government action that may prolong the issues or even deepen the crisis.
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